U.S. Housing Market, More Trouble in Squanderville

Bob, Frank and Freddie all bought identical houses in the same neighborhood in 2004. Each man paid $300,000 for his home.

Bob paid the whole $300,000 in cash. Frank put down 10% (or $30,000) and took out a $270,000 mortgage. Freddie paid $0-down on a 100% mortgage.

In 2005, home prices rose by 10% which means that Bob made 10% (or $30,000) on his original investment. Frank made 100% on the $30,000 he put down. Freddie made the biggest windfall of all--he made $30,000 in "pure profit".

Question: Which one these three men is most likely to be the banker?

If you guessed "Freddie", you're right. Banks don't like committing capital because it limits profitability. This is why the big banks have fought so ferociously for deregulation, so they're not constrained in the amount of money they can make (via credit creation) with little capital. Of course, when the banking system is propped atop tiny specks of capital, it becomes more wobbly and crisis prone. And, if asset prices suddenly nosedive--as they did when the subprimes exploded--the whole shebang can come crashing down.

The real root of the financial crisis was leverage. The banks were massively over-leveraged (some of them 40 to 1) just like our friend Freddie. This is no longer a matter of dispute. In testimony he gave to the Financial Crisis Investigation Commission (FCIC), Ben Bernanke admitted that 12 of the country's 13 largest banks were underwater.

"If you look at the firms that came under pressure in that period... only one... was not at serious risk of failure," Bernanke told the commission.

So, the banks borrowed too much and were gravely under-capitalized. So when asset prices fell, they were wiped out and the financial system crashed. It was not "the perfect storm" as Wall Street cheerleaders like to say. It was the inevitable outcome of risky behavior. There's nothing unusual about a bank run, especially when the banks are capital-depleted and acting like lunatics.

The housing market would not have collapsed if everyone had acted like Bob. (and paid in cash) In fact, things probably would have been fine if people merely put 10%-down, like Frank. The problem is Freddie. 0-down loans are inherently unsafe because they give the borrower an option to "walk away" if the market tumbles. If housing prices drop 15%, for example, the best business decision for Freddie is to leave the keys on the kitchen counter and find a cheap place to rent. In other words, 0-down creates an incentive to default. And, that's exactly what's happened.

When banks act like Freddie (over-leveraged), the situation is even more dangerous, because a run on the banks can crash the financial system and lead to a Depression. When subprime blew up, institutional investors tried to dump their mortgage-backed securities (MBS) at the same time. Trading stopped as everyone ran for the exits. The secondary market froze and the global financial system suffered a massive heart. Nearly three years later, and the patient is still in ICU on a drip-feed of zero-rates and QE2-nitro.

So, what did the banks learn from that near-death experience?

Nothing. In fact, they've rebuilt the same exact system that blew up less than 3 years ago. And, Ben Bernanke, Timothy Geithner and Barack Obama have helped them every step of the way. This is from Bloomberg:

"Bankers are fiercely resisting the suggestion that they use more equity (capital) and less debt in funding, even though this would reduce their dangerous degree of leverage...

Fixation with return on equity (ROE) also contributes to bankers’ love of leverage because higher leverage mechanically increases ROE, whether or not true value is generated. This is because higher leverage increases the risk of equity, and thus its required return. Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity....

...the structure of current capital requirements distorts banks’ decisions. The structure, which is focused on the ratio of equity to so-called risk- weighted assets, might induce banks to choose investments in securities over lending, because securities with high credit ratings require less capital and thus allow more debt funding...

The proposed solutions that regulators in the U.S. are focused on, such as resolution mechanisms, bail-ins, contingent capital and living wills, are based on false hopes. They can’t be relied on to prevent a crisis. Increasing equity funding is simpler and better than these pie-in-the-sky ideas." ("-Fed Runs Scared With Boost to Bank Dividends", Bloomberg)

What does this mean? It means that there are strong incentives for the banks to maximize borrowing and put the system at greater risk. It means that banks can't be as profitable by issuing loans to small businesses and homeowners. It means they would rather dabble in all manner of complex paper assets (so they can skim off huge salaries and bonuses) then provide money for productive activity that that creates jobs and revitalizes the country. It means that the financial system in its present configuration is just as dodgy and unstable as before. It means that we are headed for another meltdown.

Wall Street has a word for all of this. It's called "regulatory arbitrage", a fancy expression that means avoiding the rules and doing whatever-the-hell you want. This explains the widespread use of off-balance sheet operations, SIVs (structured investment vehicles), securitization, exotic derivatives contracts, and all of the other opaque debt-instruments that fall under the cheery rubric of "innovation."

All of these so-called innovations have one goal in mind, to maximize leverage so that profits can be derived from infinitesimal specks capital. The problem is, that when financial institutions are highly-geared (leveraged), it only takes the smallest downturn in the market to wipe them out. (Bloomberg: "If 95 percent of a bank’s assets are funded with debt, even a 3 percent decline in the asset value raises concerns about solvency and can lead to disruption".)

And, guess what? The banks are still up to their old tricks. Take this for example (from the New York Times):

"When the mortgage securitization market collapsed amid a flood of defaults and foreclosures — many of them on loans that should not have been made — the cry arose for lenders to have “skin in the game.” To properly align incentives, the argument went, those who make loans must suffer if the loan goes bad.

That principle was enacted by Congress last year in the Dodd-Frank law, but the mortgage industry managed to persuade legislators to insert an ill-defined loophole that would allow at least some mortgage loans — and perhaps nearly all of them — to escape the requirement that banks retain at least 5 percent of the risk....

Much of the banking industry has been pushing for an expansive definition that would leave few, if any, conventional loans subject to the skin-in-the-game requirement. To hear them tell it, there is virtually no way that any bank would make a mortgage loan at a reasonable rate if it had to share in any losses."

("Looks Like Banks Lose on Risk Plea", Floyd Norris, New York Times)

Got that? The banks still do not want to put one stinking dime behind the garbage paper they are creating. They are still fighting to securitize loans with no skin-in-the-game. See? They're all Freddies.

After the trillions in bail outs, one would think that the banks would be grateful. But, no. In fact, if the capital requirements are implemented, many of the banks may just pack up and leave. Here's the story in the Wall Street Journal:

"Some foreign banks are moving to restructure their U.S. operations to avoid one of the most-burdensome requirements of the new Dodd-Frank law.

In November, Barclays PLC quietly changed the legal classification of the U.K. bank's main subsidiary in the U.S. so that the unit would no longer be subject to federal bank-capital requirements. Several other banks based outside the U.S. are considering similar moves, according to people familiar with the matter.

The maneuver allows them to escape a provision of the financial-overhaul law that forces the pumping of billions of dollars of new capital into the U.S. entities, known as bank-holding companies.

"It's just not worth it to have all that capital trapped" in the holding company, said a New York lawyer who is advising banks on how to restructure....

Policy makers are demanding banks hold more capital and cash to help prevent a repeat of the financial crisis. But bank executives are worried that all the changes will crimp profits without making the financial system safer." ("Banks Find Loophole on Capital Rule", Wall Street Journal)

"Ingratitude, the marble-hearted beast!". Shakespeare must have known a few bankers in his day, too.

And, here's the corker; the banks are still broke. Aside from the fact that housing prices are falling sharply (increasing the banks loan losses) and that there will another 2 million foreclosures in 2011, the real condition of the banks books are still hidden from public view. Here's a glimpse from the WSJ's Michael Rapoport,:

"During the financial crisis, investors fretted over "toxic," hard-to-value assets that banks were carrying. Those fears have faded as bank profits have rebounded, loan delinquencies have declined, and bank stocks have soared 25% in the past five months.

But banks still hold plenty of the bad assets that once spooked investors: mortgage-backed securities, collateralized debt obligations and other risky instruments. Their potential impact concerns some accounting and banking observers.

In part due to those bad assets, the top 10 U.S.-owned banks had $13.8 billion in "unrealized losses" that have lasted at least a year in their investment portfolios as of Sept. 30, according to a Wall Street Journal analysis. Such losses are baked into banks' book value, but don't get counted against earnings as long as the banks believe the investments will later rebound. If those losses were assessed against earnings, it would have reduced the banks' pretax income for the first nine months of 2010 by 21%, according to the Journal analysis.

Unrealized losses are just one way in which the troubled assets obscure banks' true financial condition, accounting experts say....Another problem: Even when banks do take real charges because of their securities losses, accounting rules allow them to keep some of those charges from hurting their bottom line.

Making the picture even murkier, the value of many risky assets are based solely on the banks' own estimates—leaving valuations uncertain and, some critics say, overstated....

One problem centers largely on "Level 3" securities, illiquid investments that can't be easily valued using market prices. According to the Journal analysis, as of Sept. 30, the top 10 banks had $360.7 billion in "Level 3" securities. That amounts to 42.6% of the banks' shareholder equity, a pile of assets whose value is hard to verify." ("Toxic' Assets Still Lurking at Banks", Michael Rapoport, Wall Street Journal)

"$360.7 billion" in garbage assets and financial stocks are still in the stratosphere?!? No wonder Bernie Madoff called the whole thing a "Ponzi scheme".

No one knows the true condition of the banks books because the accounting fraud is so thick that's it's impossible to see through it. Here's the scoop from the WSJ on how the Financial Accounting Standards Board (FASB) caved in to Wall Street and gave them the go-ahead to lie as much as they want:

"The banks got what they wanted. Accounting rule makers on Tuesday dropped a plan to require banks to value loans using market prices.

That means investors will remain reliant on banks' own views of the worth of their assets. Those judgments proved seriously flawed during the financial crisis and left many with insufficient capital. Taxpayers, who as a result were called upon to bail out numerous institutions, also are left more vulnerable.

The Financial Accounting Standards Board's original proposal, put forward last spring, had called for banks to reflect market values in the total worth of their assets, which would affect their equity....Banks generally oppose the use of market prices because, they say, it makes their results more volatile. Their intense lobbying efforts against the proposal likely got a leg up after FASB Chairman Robert Herz, who had supported the plan, unexpectedly departed in August. FASB cited strong opposition it received in public comments in changing course.

Its decision means banks largely will continue to value loans as they do today, basing values on their original cost less a reserve to reflect the possibility of loss. FASB has yet to decide if the market value for loans will be disclosed on the balance sheet or buried in the footnotes, as they are now." ("Banks get the green-light to cook the books", Wall Street Journal)

So, imagine that you, dear reader, took out a loan at the bank by posting your $2.5 million dollar home in Beverly Hills and your custom Maserati for collateral. Now imagine that the banker decided to check up on your claim and found that you actually rode a rusty Schwinn bike to your job of collecting cans by the side of the freeway and lived in a cardboard lean-to next to the sewage-treatment plant. How long do you think it would take before the bank recalled your loan? Of course, if you were a banker and had an army of lobbyists working for you, you could lie to your heart's content and no one would be the wiser. But the truth remains: the banks are broke. The rest is smoke and mirrors.

One last thing: Along with the accounting shenanigans, the toxic assets, the non performing loans and the gigantic leverage, the banks are also hiding millions of REOs "off market" to keep housing prices from plunging even further. This "shadow inventory" will continue to be a drain on bank resources while keeping house prices "bouncing along the bottom" for years to come. Here's a clip from an article by Mark Whitehouse:

"Banks’ vast pile of foreclosed homes doesn’t appear to be diminishing. That’s a troubling sign for the future of the housing market.

Back in April, this column tallied up all the foreclosed homes sitting in banks’ inventory, as well as the “shadow” inventory of homes in the foreclosure process or on which owners had missed at least two mortgage payments. At the time, we reported that at the current rate of sales, it would take 103 months to unload it all.

Over the past six months, that number has actually risen. Banks managed to pare down the shadow inventory, but largely by taking possession of foreclosed homes. As of September, they owned nearly 994,000 foreclosed homes, up 21% from a year earlier. The shadow inventory stood at 5.2 million homes, down 7% from a year earlier. Grand total: 107 months of inventory.

The numbers aren’t exactly comparable to the April analysis, as the providers of data have changed. The inventory data now come from RealtyTrac, the shadow inventory data from LPS Applied Analytics, and the sales data from Core Logic. But no matter how you slice it, the housing market faces almost nine years of foreclosure hangover.....

The dismal plight of the housing market hasn't changed much since Whitehouse wrote this article a couple months ago. The bleeding continues and prices are falling fast. If Obama doesn't come up with a remedy soon, the banks will be back on the front steps of the US Treasury with their begging bowls in hand. You can bet on it.

Botton line: The people who caused the financial crisis have reassembled the same system piece by piece paving the way for another massive meltdown.

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